Given the volatility in the markets and the uncertainties ahead in our economy we were pleased to host Mike Green, Chief Strategist and Portfolio Manager for Simplify ETFs to discuss the potential challenges ahead, on our most recent Advance Your Wealth video series. The conversation focused primarily on the Federal reserve and the implications their historic rate hiking cycle has on our economy and we have summarized the key talking points below.
To watch the full video, click here: Markets in Turmoil – The Role of the Fed featuring Mike Green of Simplify Asset Management
The bond bear market might be worse than the stock bear market.
As interesting and as volatile as the stock market has been, it pales in comparison to what’s happening in the bond market because the characteristics of bonds are changing. To understand let me explain a bonds relationship to interest rates. Most bonds pay the investor a fixed interest payment so as interest rates fall the demand for that bond at a previously higher fixed interest payment goes up, making the bond more valuable. The opposite is true as rates rise, that bond then becomes less attractive because it’s now paying less than the current rate, in turn causing the price of the bond to drop.
Why this is important, is because historically bonds not only provided income, they have also provided protection in a portfolio. When economic growth is strong, stocks historical rose alongside interest rates. When growth was weak, interest rates will often fall, increasing the value of bonds, or at least holding steady, providing protection when stocks were struggling. Over the last 40 years investors have used a bond’s hedging characteristic to allow a higher allocation to stocks than they otherwise would have. What this looks like for most investors is a portfolio that is something close to 60% and 40% bonds.
What has changed in the last two years is that stocks and bonds are no longer inversely correlated and this has led to a challenging environment for most investors at what once was the ballast to their portfolio is down almost as much as their stock portfolio. It can be expected to see your stock portfolio go down when market and economic conditions are difficult, however, it can be much more difficult to watch what you thought was the conservative part of your portfolio go down just as much. Investors should be looking for defensive asset classes outside of bonds to provide the protection to their portfolio, such as Trend Following and Long Volatility.
Is there more downside or upside risk in the market?
One interesting part of the discussion with Mike focused on how bad the current economic conditions were and that a recession is essentially already baked into the numbers. If the economy continues to slide while the Fed continues to aggressively raise interest rates to fight off inflation, this could lead to a severe enough recession where we see a large amount of layoffs in the workforce, which would then take the one major support of the current market off the table – passive 401k flows.
We went through the housing market data which paints a pretty troubling story for where things might head in the very near term. We discussed that because of risks like this, the most institutional investors had already de-risked their portfolios, reducing equity exposure or at least adding hedges. However, passive buying would likely continue as very few retail investors adjust their 401k allocations during bear markets.
Mike believes that this could actually create some level of a floor to how far the market can fall as most of the discretionary selling as already happened. If however, we did see a recession large enough to have significant layoffs, the passive flows that are currently supporting the market by systematically buying every pay period could suddenly drop enough to cause more selling pressure.
While this might seem like the more likely scenario, Mike pointed out that if this doesn’t happen, and if the Fed pivots sooner than later, then there is a risk that the market could rally significantly in a very short amount of time as all the institutional investors try to get back into the market with no one to buy from, meaning we could see the market rally very sharply.
The key to this is having an investment strategy that has enough defense to protect against the downside scenario while also having enough offense to capture enough of the upside should the market rally.
Zombie companies and rising rates.
There is also another potentially major risk that we’ve been watching very closely with regards to higher interest rates and U.S. corporations. During the last 2 years many companies were forced evolve and adapt by changing everything from their business structure to the products or services they offer. Some companies and industries found this easier to do than others but almost all of them used historically low interest rates and debt to help finance these changes. For many of these companies, it was only the ability to rollover their debt on a regular basis with these extremely low rates that have allowed them to survive as their current profits do not cover all of their financial obligations – hence the term “zombie companies.”
Mike pointed out in an interview with CNBC in June of this year that almost 25% of the Russell 3000 was already in this position, before rates reached the current levels around 4%. Many of these corporations are using short term debt structures and were able to refinance at very low rates during the pandemic. However, over the coming 6-18 months, many of these companies are gong to have to roll that debt at these higher rates and could cause a waive of downgrades and potential bankruptcies.
While this poses as a major risk for each of these companies, if enough of them get to this stage it poses systematic risks throughout the economy given the size of the corporate debt market. As of now this seems to be a year or two away but something that is growing in concern as we closely monitor situation.
All of these issues that were highlighted during our conversation are good reminders to have an investing approach that goes beyond the traditional 60/40 portfolio. Incorporating a more “All Weather” approach could have a better chance of navigating the volatility and the changing correlation between stocks and bonds which we have seen play out so far this year.
Mike Green is the Portfolio Manager and Chief Strategist with Simplify Asset Management and is not affiliated with Integrated Financial Partners or Konvergent Wealth Partners and is a separate entity.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.